Has global stag-deflation arrived?

Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort

By Nouriel Roubini

ILLUSTRATION: MOUNTAIN PEOPLE

The latest macroeconomic news from the US, other advanced economies and emerging markets confirms that the global economy will face a severe recession next year. In the US, recession started last December, and will last at least until next December — the longest and deepest US recession since World War II, with the cumulative fall in GDP possibly exceeding 5 percent.

The recession in other advanced economies (the euro zone, the UK, the EU, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then.

There is now also the beginning of a hard landing in emerging markets as the recession in advanced economies, falling commodity prices and capital flight take their toll on growth.

Indeed, the world should expect a near recession in Russia and Brazil next year, owing to low commodity prices, and a sharp slowdown in China and India that will be the equivalent of a hard landing (growth well below potential) for these countries.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better, and some may experience full-fledged financial crises. More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Ecuador and Venezuela in Latin America.

Most of these economies can avoid the worst if they implement the appropriate policy adjustments and if the international financial institutions — including the IMF — provide enough lending to cover their external financing needs.

With a global recession a near certainty, deflation — rather than inflation — will become the main concern for policymakers. The fall in aggregate demand while potential aggregate supply has been rising because of overinvestment by China and other emerging markets will sharply reduce inflation. Slack labor markets with rising unemployment rates will cap wage and labor costs.

Further falls in commodity prices — already down 30 percent from their summer peak — will add to these deflationary pressures.

Policymakers will have to worry about a strange beast called “stag-deflation” (a combination of economic stagnation, recession and deflation); about liquidity traps (when official interest rates become so close to zero that traditional monetary policy loses effectiveness); and about debt deflation (the rise in the real value of nominal debts, increasing the risk of bankruptcy for distressed households, firms, financial institutions and governments).

With traditional monetary policy becoming less effective, non-traditional policy tools aimed at generating greater liquidity and credit (via quantitative easing and direct central bank purchases of private illiquid assets) will become necessary. And while traditional fiscal policy (government spending and tax cuts) will be pursued aggressively, non-traditional fiscal policy (expenditures to bail out financial institutions, lenders and borrowers) will also become increasingly important.

In the process, the role of states and governments in economic activity will be vastly expanded.